Is it Time to Buy Japanese Stock Mutual Funds?

After Japan's stock market soared 80 percent over the course of six months, it hit a roadblock. The rapid climb of the Nikkei 225 index, the market's benchmark, came to an abrupt end on May 22. Over the next three weeks, the market plunged 20 percent -- the definition of a bear market.

However, since June 13, the day it entered bear territory, the Nikkei has bounced back 13 percent. The quick turnaround has led many to ask if this market correction is a buying opportunity, or merely a head fake as the Japanese market returns to the doldrums it's been sitting in for the past two decades.

"The historical template for Japan over the last 20 years has been, the government announces measures, markets do well, and six months later we're back where we started," says Christopher Dodson, Japan capital markets specialist at Auerbach Grayson, a New York broker that provides access to international markets. "That history was the prime reason for the severity of the dive."

The Japanese market began its rally in November with the dissolution of Japan's parliament, which paved the way for the election Prime Minister Shinzo Abe. But it was Abe's package of policies to grow Japan's moribund economy that really sent stocks soaring.

The prime minister proposed a three-sided plan to spark economic growth. Nicknamed "Abenomics," the plan consists of loosening monetary policy, increasing public works spending and making structural reforms throughout the economy. The monetary stimulus aims to end the problem of deflation, or falling prices, by decreasing interest rates to ultimately produce 2 percent inflation within the next two years. Finally, the structural reforms include tax cuts and an easing of regulations.

So far, the monetary stimulus has had the biggest effect. From November through May, the yen declined in value against the dollar by 30 percent, which is good for Japanese exporters because it raises the value of their overseas earnings and helps make their products less expensive abroad. After a short recovery, the yen is down 25 percent as of July 3.

"Monetary policy by itself is not enough," says Paul Attwood, portfolio manager of the Huntington International Equity fund (HIETX) and Huntington Global Select Markets fund (HGSIX). He says corporate tax rates must be lowered and some regulations eliminated in order to see sustainable economic growth. Even so, the country is his top pick among international markets, and his funds have a 20 percent stake in Japan. Attwood says the stocks are attractively valued and the downside is limited, so he's looking to buy more. He suggests U.S. investors put 5 percent of their portfolios in Japan.

The trigger for the Nikkei's tumble was the U.S. Federal Reserve. On May 22, Fed Chairman Ben Bernanke said if the U.S. economy continued to improve, the central bank could begin to wind down its policy of buying Treasury bonds, known as quantitative easing. Fears that ending the policy would slow down the U.S. economy sparked a worldwide sell off in stocks. The same day, China, Japan's second-largest trading partner, released poor economic news. That one-two punch sent the Nikkei reeling.

Over the five weeks ended June 26, U.S. mutual funds holding only Japanese stocks saw net outflows of $472 million, or 21 percent of their assets, according to Morningstar.

Emerging markets are down a lot this year and Europe is still struggling. "Japan is in the best shape in the world," says Campbell Gunn, portfolio manager of the T. Rowe Price Japan fund (PRJPX). He says Japan is "pulling out all the stops to recover and the valuations are still attractive."

At this point, everyone is waiting for the end of July, when Japan's parliament holds elections for its upper house. If Abe's party wins, he'll be able to push through all of his policies.

Dodson of Auerbach Grayson says if investors want Japanese stocks they should focus on domestic asset plays, companies that aren't heavily influence by events outside of Japan. He likes real estate, construction, railroads, and domestic retail such as Mitsubishi Estate (MITEY), East Japan Railways (EJPRY) and Seven & I (SVNDY). Also, small-capitalization stocks generally outperform given their domestic bent, he says.

Martin Jansen, the lead portfolio manager for the ING International Value fund (NIIVX), also likes domestic retail and financials, and boosted his fund's Japan weighting to 21 percent over the past 7 months.

If you want to get in on Japan's potential turnaround, Japan funds are the way to go. Even with the recent bear market, Japan funds declined 1.86% in the last month, that's less than any other international stock sector fund, according to Morningstar. They still lead that group year to date. But it's a turnaround story. Investors have lost money in Japan over the last decade, so you'll want to limit your stake and keep tabs of the developments, as Abenomics is an unfolding story.

Although many say this is indeed a buying opportunity, there are some caveats. John Browning, the executive director of Incapital's unit trust division and a creator of international portfolios says historically, throwing money at a problem doesn't necessarily work. Japan's stimulus may result in inflation without real economic growth. What's more, Japan also faces increased competition in terms of innovative new products from China and other emerging market countries.

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